Experts have called for tax breaks for property to be scrapped or restricted after the Murray inquiry described the housing market as a “significant source of risk for the financial system and the economy".

The report said tax breaks such as negative gearing and capital gains tax concessions had encouraged Australians to take on debt to buy property and increased the risks of households getting in trouble.

“A large enough disruption to the housing market could have significant implications for household balance sheets, financial stability, economic growth, and the speed of recovery in household spending and broader economic activity following a shock."

But the report stopped short of making any firm policy recommendations, leaving it to be dealt with in the Abbott government’s coming tax white paper.

The report also noted Australia’s dividend imputation system – where tax paid by companies can be imputed to shareholders by way of a credit, allowing them to reduce their taxable income – created a bias where individuals and super funds preferred shares. This had hindered the growth of the domestic corporate bond market, it said.

The Murray report said the fact housing was taxed concessionally had encouraged “leveraged and speculative investment". It said banks favoured housing loans over business loans. Since the Wallis Inquiry in 1997, the share of loans for housing has increased from 47 per cent in 1997 to its current share of 66 per cent and this focus on housing had reduced the amount of, and increased the price of, business lending.

Buying not building

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Bank of America Merrill Lynch economist Saul Eslake, who has long advocated scrapping negative gearing, said tax breaks for housing had inflated house prices. “It has contributed to the decline in housing affordability for home buyers while doing nothing to increase the supply of rental housing," he said.

The report said since 1997, household leverage had increased markedly, with over 90 per cent of the increase in household credit due to ­borrowing for housing. It said since 1997, only 10 per cent of the flow of housing finance had been for building new dwellings, which had not been sufficient to meet population growth over the past decade.

Grattan Institute senior associate
Paul Donegan
said as well as an option to limit negative gearing to new homes, the government could quarantine the tax losses generated from ­negative gearing, as the Hawke government did in 1985 for two years before the housing lobby won a change.

“In 1985 the rules changed so that you could still offset profits from investment property against your mortgage but you couldn’t use them to reduce your taxable income from your wages," Mr Donegan said. “That was in place for two years until there was outcry from the property industry."

Mr Donegan said the government should also look at restricting the 50% CGT discount for investors introduced by the then Howard government in 1999. “You could revert to the previous set of arrangements ... so that indexation cuts inflation out of your profit. It essentially taxes you on your capital gain above inflation."

An incentive to reduce repayment

The report said the change in capital gains tax arrangements had reduced the tax burden of holding an investment property for shorter periods and had contributed to the growth in investor housing credit and investors’ shift to more leveraged investments over the past 15 years.

“Because of these tax arrangements, owners of residential property have an incentive to repay their mortgage as slowly as possible to maximise the tax deductions they can accrue," the report said. “Loans with interest-free periods help to maximise these tax deductions in the early years of a loan, although these loans also give borrowers more flexibility with repayments. The tax system, therefore, encourages individuals to take on more risk, which does have implications for risks to lenders."

The report said although these tax arrangements apply to other leveraged investments, such as shares, “investors perceive housing investment as less risky than leveraged securities investment" and there was “a widespread and falsely held view that housing prices never fall".

It said tax incentives for shareholders, such as dividend imputation, ­created “distortions" and potential risks without clearly reducing the “cost of capital" in Australia. The report said the case for retaining dividend imputation is less clear than it was in the past.

“By removing the double taxation of corporate earnings, the introduction of dividend imputation reduced the cost of equity, and so contributed to the ­general decline in leverage among­non-financial corporates," it said.

“ The benefits of dividend imputation, particularly in lowering the cost of capital, have arguably declined as Australia’s economy has become more open. The dividend imputation system creates a bias for individuals and institutional investors, including superannuation funds, to invest in domestic equities. As such, dividend imputation may be affecting the development of the domestic corporate bond market."

KPMG partner
Jenny Clarke
, said it was a shame the inquiry deferred tax issues to the white paper process. “Just 14 pages out of 460 are devoted to tax, yet there are many financial services–specific tax subjects which we feel the inquiry could reasonably have been expected to give direction on," she said.

Ms Clarke agreed with the report’s recommendation that the system had created a bias towards shares, particularly in terms of super funds.

“We need to think about how to get longer term investment for the retail market, tax incentives for people providing long term debt, or something as simple as interest withholding tax exemptions," she said. “That would encourage more funds to come to Australia."